By Rupert Hargreaves at ValueWalk
China’s FX reserves could fall to $2.8 trillion, the lower end of the IMF’s recommended range within a few months, which could spark a tidal wave of speculative selling, forcing the People’s Bank of China (PBoC) to throw in the towel and let the market decide the level of the renminbi exchange rate — that’s according to Société Générale’s perma-bear Albert Edwards.
In this week's issue of Société Générale's Global Strategy research note, Edwards writes that "China hasburned through almost $800bn of its FX reserves mountain since it peaked at almost $4 trillion in mid-2014. January’s FX data to be released this weekend is set to register another sharp drop of $120bn (consensus estimate)." He goes on:
"But at $3.2bn the market remains content that massive firepower remains to support the renminbi. It does not. Our economists estimate that when FX reserves reach $2.8 trillion – which should only take a few more months at this rate – FX reserves will fall below the IMF’s recommended lower bound. If that occurs in the next few months, expect to see a tidal wave of speculative selling, forcing the PBoC to throw in the towel and let the market decide the level of the renminbi exchange rate."
Edwards' view is based on the predictions of Société Générale's China economist Wei Yao. Wei Yao has written that in her view, the PBoC might, “move to a free-float within six months, after burning through a significant amount of FX reserves."
The PBoC is running out of time
Both Yao and Edwards' doom-mongering is based on the level of China's FX reserves. China has been depleting its FX reserves in an effort to slow the pace of currency depreciation. However, if the country continues to spend its reserves at the current rate, FX reserves will fall through the $2.8 trillion level that the IMF believes is the lowest acceptable level. The IMF's 'lowest acceptable' reserves level is based on four specific elements that reflect potential drains on the balance of payments: (1) exports, (2) broad money, (3) short-term external debt, and (4) other liabilities (long-term external debt and portfolio liabilities). Société Générale's analysts believe that (assuming the level of short-term external debt at remaining maturity was unchanged from year-end 2014) China’s reserves are at 118% of the recommended level (estimated to be $2.8 trillion).
If China's reserves fall below the key $2.8 trillion level, the market could lose confidence in the PBoC’s ability to resist currency depreciation and manage future balance of payments shocks. Only two major emerging market countries (Malaysia and South Africa) have reserves that are below the IMF’s recommended range and many EM countries now have a more robust reserve balance than China in terms of the percentage above the IMF's recommended minimum.
With so many hedge funds and traders betting against the yuan, (see: The Big Short 2: Hedge Funds Bet Billions On China’s Fall) the market is going to become increasingly transfixed by both the rate of decline in China's FX reserves and with the approach of the key $2.8 trillion level. As a result:
Even in the absence of actual currency weakness, any further large falls in reserves will only generate additional selling pressure in a frenzy of speculation of an imminent devaluation. The authorities’ efforts to fight the avalanche of selling by a reintroduction of selected capital controls are unlikely to succeed in my view as the capital account was pretty leaky even before the recent liberalisation. And since the spending of FX reserves imposes a monetary tightening on the economy - and one which is only intensifying – there is a limit to how much the Chinese economy can withstand.
It looks as if the hedge funds that are betting against China's currency are closing in on a bumper pay day.